How blockchain can overcome barriers, unlock growth in Islamic finance

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Two characteristics of blockchain technology are transparency and immutability. These features align well with the Shariah principles of Islamic finance, a sector projected to command approximately $6.7tn in assets by 2027, according to the LSEG’s Islamic Finance Development Report.

Islamic finance requires transactions to comply with Shariah law and ethical guidelines. As such, it operates on principles that prohibit interest, uncertainty, and involvement in speculative activities.

Several aspects of blockchain align well with these principles by reducing fraud and facilitating decentralised transactions. According to Moody’s, innovations such as smart contracts would likely improve Islamic transactions by increasing transparency, automating enforcement of Shariah-compliant rules, reducing the risk of human error and facilitating real-time settlements.

Blockchain technology also presents a promising avenue for obligatory charitable giving (Zakat) in Islam. The technology can modernise the collection and distribution processes in Islamic finance, providing a more inclusive and efficient platform for capital market transactions, such as the issuance of Sukuk (Islamic bond-like securities), all in alignment with Shariah principles.

However, the marriage of blockchain and Islamic finance has its challenges. Digital assets, including unbacked cryptocurrencies and tokenised assets, have sparked debates over their compatibility with Shariah principles and suitability for adoption into Islamic finance.

One of the primary challenges is these assets’ potential for speculation and anonymity, which diverge from Islamic finance principles that emphasise transparency, accountability and ethical conduct. In Islamic finance, the concept of central bank digital currencies (CBDCs) aligns with the principles of transparency, fairness and social welfare as outlined in Shariah law.

By digitising the national currency, Islamic countries can offer a more efficient and accessible payment system while ensuring compliance with Islamic financial principles.

Innovation in UAE Islamic finance

The UAE, which has a well-developed and well-regulated Islamic finance sector, stands out as a significant digital assets hub. The Gulf state is leading the charge in technological innovation and embracing the digital economy through forward-thinking digital assets regulation.

Oversight of the regulatory framework for digital assets primarily falls under two key federal bodies: the Securities and Commodities Authority (SCA) and the UAE central bank. While the SCA focuses on securities-related matters, the central regulates activities concerning digital currencies and stored value.

The UAE has three additional jurisdictions for digital assets regulation, including the Dubai International Financial Center, regulated by the Dubai Financial Services Authority (DFSA); the Abu Dhabi Global Markets (ADGM), regulated by the Financial Services Regulatory Authority (FSRA), and the dedicated Virtual Assets Regulatory Authority (VARA).

Each regulator in the UAE approaches virtual assets regulation differently, with variations in their scope and focus. The regulatory landscape continuously evolves to align with international trends, underscoring the dynamic nature of digital assets regulation in the UAE.

To fully leverage the benefits of blockchain and digital assets, Islamic finance institutions will likely need to craft comprehensive adoption strategies that encompass technology integration, Shariah compliance, regulatory compliance, risk management and customer education.

Collaboration with Shariah scholars and experts is expected to be essential to ensure that blockchain initiatives and digital asset offerings align with Islamic ethical and legal principles. Numerous Islamic banks and financial institutions are actively integrating blockchain technology to streamline operations.

Though they face challenges such as regulatory compliance and difficulties with interoperability between blockchain and legacy systems, these institutions are actively seeking solutions to unlock blockchain’s full potential.

Read: Revolutionising Islamic finance: The transformative impact of blockchain technology

The author is the svp & head of Strategy, Digital Economy at Moody’s Investor Services